Credit Markets as Leading Economic Indicators

Big US banks reported the lowest loan losses in eight years in the second quarter, reflecting tighter lending standards since the financial crisis.

Despite gloomy predictions for the quarter, big US lenders largely beat analysts’ earnings expectations as lending strengthened and credit quality improved.

That is from the FT.  Six of the biggest banks have reported credit losses of 0.6% of total loans, rather than the 3.3% from the peak of the crisis.  That’s a big improvement.  Yet credit is now expanding steadily.

Alternatively, if we look at the eurozone, credit indicators, especially to small and medium-sized enterprises, have remained unimpressive to say the least.


That is consistent with the continued sluggish growth coming out of many eurozone countries.

But are credit indicators reliable today?  They are currently sending the most bullish signals about the U.S. economy and the most bearish signals about the eurozone.  If we look at output, especially the first quarter U.S. gdp downgrade, matters don’t seem nearly so rosy for our friends the Americans.  Alternatively, if we look at bond rates within the eurozone, it would appear that the crisis is over.  Across some margins Spain can borrow more cheaply than can the U.S. government.  But then why do we not see credit vitality spreading across the eurozone more generally?

How much today are credit markets to be trusted as leading economic indicators?  That is perhaps the single most critical question about economic forecasting, circa July 2014.  The case for the relevance of credit market indicators involves some of the following:

1. Who is willing to borrow and lend to commercial enterprises is an acid test of economic recovery, one which America is (partially) passing and much of the eurozone is failing.

2. Credit markets were so thoroughly burned 2008-2009 that they can’t be fooled so easily again.  If the rejected suitor is willing to try once more, perhaps this time around it is true love.

3. The credit cycle has proven a good indicator of the business cycle at least since Schumpeter and Wesley Chair Mitchell, arguably much longer than that (read Henry Thornton in 1803!).

The case against credit market indicators, at least circa July 2014, is the following:

1. Central banks have manipulated too many credit markets with QE and with guarantees.

2. It seems credit markets are too easily manipulated by psychology.  Lending officers keep their jobs only by making loans, so we can’t trust bank loans this time around either.  The incentives just aren’t right.

3. When leading indicators are not unanimous or near-unanimous, that is a sign that volatility is still underway, if perhaps hidden under the surface, and markets have not found themselves a new equilibrium.  Doubt and debate are not a good sign here.

When will we know which perspective is correct?  Perhaps the most important point is this: to reap the gains from being heavily invested in equities, you have to be invested all the time, not just on the days which look good in advance.  Caveat emptor nonetheless…


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